A price war has driven the cost of some stock trades to zero. But brokerages have to make money somehow, and here are some of the ways.
Investing is cheaper than ever. Trading is free, some index funds may as well be, and a diversified portfolio can be built by machines for a fraction of the cost of live professionals who deliver advice in an elegant leather binder.
In the space of a few days last month, the price war among the brokerage firms pushed the cost for many trades to nothing at Charles Schwab, TD Ameritrade, E-Trade and Fidelity. Then, this week, Schwab said it would acquire Ameritrade for $26 billion — a deal that demonstrated the importance of market share in an era of cheap investing.
But low-cost investing isn’t always as cheap as it appears. Many companies, in stamping out certain fees, are doing other things that can cost you money — and it’s up to you, dear investor, to figure out what they are.
Each firm’s policies differ, but here are helpful places to look: the way your brokerage uses your cash holdings; the costs of other services it offers; and how it might be profiting off your free trades by getting someone else to pay for them instead.
Over the past decade, online brokerages and wealth management firms have started to make more money off customer cash — money that hasn’t been invested yet, for example — by sweeping it into lower-yielding deposit accounts instead of higher-yielding money market funds, said Michael Wong, director of financial services equity research at Morningstar.
Schwab, for example, will pay you a meager 0.06 to 0.45 percent of your assets, while investing it at roughly 2.65 percent, and pocketing the difference, he said. Cash holdings might earn nearly 2 percent elsewhere.
And that has paid off for the company: Net interest revenue made up nearly 60 percent of Schwab’s overall revenue last year. TD Ameritrade and E-Trade have similarly leaned on interest income, which represented more than half of each firm’s revenue last year.
Fidelity, which has a giant 401(k) business, doesn’t rely as heavily on interest — and earlier this year, it said all of its retail accounts’ idle cash would be swept into higher-yielding money market accounts. Vanguard does the same thing.
So yes, free trading is a nice little perk — but you’re most likely paying for it in the form of lower returns on the cash your broker is holding.
And free trades might not even be worth that much to you. Few enlightened investors are chasing hot stocks anymore; they’re buying and holding a diversified mix of index funds to help them pay for big life events like college and retirement. (Index funds are basic mutual funds that track wide swaths of the stock market.)
The big brokerage firms know this, and many of them have followed the lead of smaller, upstart firms like Betterment, which are known as roboadvisers, to provide mass-manufactured digital portfolios that operate largely on autopilot, and cost very little.
Schwab introduced its own digital investment service in 2015, and tried to one-up its competitors by making its service “free.” But there was a catch.
Many roboadvisers typically charge an overall fee — say roughly 0.30 to 0.50 percent of a customer’s assets annually — along with the (usually very low) underlying cost of the investments. Schwab omitted that overall fee, charging just the cost of the underlying funds.
But investors must keep anywhere from 6 percent to 29 percent of their portfolio in cash, which currently pays 0.45 percent, according to a Schwab spokesman. Schwab earns more money the bigger the allocation is.